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I don’t understand how you can call Algonquin Power & Utilities Corp. (AQN) and Northland Power Inc. (NPI) “bargains” when they both have price-to-earnings multiples in the 25-30 range! The only thing that supports the price is the yield. The yields will need to increase as interest rates rise. Where will the price go?

I chose this reader’s e-mail because it illustrates how P/E multiples can sometimes lead investors astray. Today, I’ll dig a little deeper into the meaning of P/Es, using Algonquin and Northland as examples. Then, I’ll address the reader’s question about interest rates. (Globe Unlimited subscribers can read the original column here.)

P/E ratios are easy to find. Presumably, the reader looked up Algonquin’s P/E on a financial website such as and saw that it was 26.7 – evidently way too high for his liking. But the ratio can be measured in different ways, and it’s important to understand what a particular P/E means before passing judgment on a stock.

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In this case, the P/E was apparently calculated by dividing Algonquin’s recent stock price of about $12.80 by last year’s earnings per share 48 cents. This “trailing 12 months” P/E doesn’t tell the full story, however, for a couple of reasons.

First, it’s based on net earnings, which often contains one-time items that distort a company’s bottom line. If you go to Algonquin’s year-end 2017 earnings release, the company also provides an “adjusted net earnings” number that excludes gains or losses on foreign exchange, litigation expenses and other “typically non-recurring items.” Using Algonquin’s adjusted 2017 earnings of 74 cents a share for the denominator, the trailing P/E drops to a more reasonable 17.3. (Granted, adjusted earnings has no standard definition and could be open to manipulation by companies, which is something investors need to watch for.)

The second reason that a trailing P/E doesn’t provide a complete picture is that it’s backward-looking and doesn’t reflect a company’s expected earnings growth. Algonquin has been making acquisitions and investing in its existing operations, and analysts, on average, expect that earnings will climb to 75 cents a share this year and 83 cents in 2019. Using the 2019 earnings estimate, the forward P/E falls to 15.4.

Just to complicate things further, many analysts also use variations of the P/E that are based on cash flow instead of accounting earnings. Bill Cabel of Desjardins Securities, for instance, estimates that Algonquin will have adjusted free cash flow (FCF) per share of $1.11 this year, which translates into P/FCF ratio of just 11.5. Based on these other measures, Algonquin doesn’t look nearly as expensive as the trailing P/E would suggest.

Turning to Northland Power, its trailing P/E is a seemingly lofty 27, but again, that doesn’t mean the stock is outrageously expensive. Because earnings of power producers can be affected by non-cash accounting items such as accelerated depreciation and the fluctuating values of derivative contracts, “power companies are much better thought of from a cash flow perspective,” Jeremy Rosenfield of Industrial Alliance Securities said in an interview.

Based on Northland’s recent stock price of $23.63 and reported free cash flow of $1.46 a share in 2017, the stock’s trailing P/FCF multiple is about 16.2. Mr. Rosenfield estimates that Northland’s FCF per share will climb to $1.73 this year, which equates to a forward P/FCF multiple of about 13.7 – or roughly half of the trailing P/E.

The lesson here is that, when you’re looking at a P/E ratio, you need to understand how it’s measured and evaluate it in the context of a company’s earnings and cash flow growth. Generally, companies that are growing rapidly will have higher P/Es, while slow-growing companies will have lower P/Es.

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Now, what about the relationship between interest rates and stock prices? Well, that’s also not as straightforward as some people might think.

The stock market is forward-looking, which means that it reflects not only where interest rates are now, but where investors believe rates are heading. As my previous column pointed out, shares of many utilities and power producers have dropped significantly, indicating to some analysts that certain stocks may already be pricing in further increases in interest rates. If that’s the case, then the downside risk for the these stocks could be limited even if rates continue to rise modestly.

It’s also worth mentioning that many power and utilities stocks raise their dividends regularly. Algonquin, for instance, aims to hike its dividend at an annualized rate of 10 per cent. If a company’s earnings, cash flow and dividends are growing, these factors should help to counter the impact of rising rates.

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